Before buying shares, investors must understand the company’s use of leverage for risk and returns.
As Indian markets are sinking due to shock waves from Shanghai, one could see many companies’ shares are available at cheap price.
Obviously, you are tempted to pick those shares. But, while selecting shares you should keep in mind the extent to which firms use leverage which will help you to assess company’s risk and return characteristics.
What is leverage and why do you bother?
Leverage is the use of fixed costs in a company’s cost structure. Fixed costs that are operating costs such as depreciation or rent which create operating leverage whereas fixed costs that are financial in nature like interest expense create financial leverage in companies.
Before selecting a company’s share, investors need to understand company’s use of leverage for multiple reasons.
First, leverage increases the volatility of a company’s earnings and cash flows and increases the risk of owning a company. Second, it helps the investors to discern information about a company’s future prospects from management’s decisions about the use of operating and financial leverage. Third, the valuation of a company requires forecasting future cash flows and assessing the risk associated with those cash flows. Understanding a company’s use of leverage should help in forecasting cash flows and in selecting an appropriate discount rate for finding their present value.
Risk measurement through leverage
Business risk is the risk associated with operating earnings. Operating earnings are affected by sales and costs of producing goods/services. Sales are affected by a large number of factors, including economic conditions, industry dynamics, government regulation, customer preferences, etc. Therefore, prices of the company’s goods or services or the quantity of sales may be different from what is expected.
Operating risk is the risk attributed to the operating cost structure, in particular the use of fixed costs in operations.
The greater the fixed operating costs relative to variable operating costs, the greater the operating risk. Business risk is therefore the combination of sales risk and operating risk. Companies that operate in the same line of business generally have similar business risk. Even within the same line of business, companies can vary their fixed and variable costs to some degree.
The degree of operating leverage is the ratio of the percentage change in operating income to the percentage change in units sold. For example, if degree of operating leverage at a given level of unit sales is 2.0, a 5% increase in unit sales from that level would be expected to result in a (2.0)(5%) = 10 per cent increase in operating income.
Financial risk is the risk associated with how a company finances its operations. If a company finances with debt, it is legally obligated to pay the amount that make up its debts when due. By taking on fixed obligations, such as debt and long-term leases, the company increases its financial risk. If a company finances its business with equity, it does not incur fixed obligations. The more fixed-cost financial obligations (e.g., debt) incurred by the company, the greater its financial risk.
We can quantify this risk in the same way as we did for operating risk, looking at the sensitivity of the cash flows available to owners when operating income changes. This sensitivity, is popularly known as degree of financial leverage which is measured as percentage change in net income divided by percentage change in operating income.
For example, if degree of financial leverage at a given level of operating income is 1.1, a 5% increase in operating income would be expected to result in a (1.1)(5%) = 5.5 per cent increase in net income. Combining both operating and financial leverage we can arrive at the total leverage of a firm.
The valuation of a company and its equity is affected by the degree of leverage. The greater a company’s leverage, the greater the risk and, hence, the greater the discount rate that should be applied in its valuation. Further, highly leveraged firms have a greater chance of incurring huge losses during downturns, which could lead to financial distress and bankruptcy.
* Valuation of a company and its equity is affected by the degree of leverage. The greater a company’s leverage, the greater the risk and, hence, the greater the discount rate that should be applied in its valuation
* Business risk is the risk associated with operating earnings. Operating earnings are affected by sales and costs of producing goods/services
* Operating risk is the risk attributed to the operating cost structure, in particular the use of fixed costs in operations
* Financial risk is the risk associated with how a company finances its operations. If a company finances with debt, it is legally obligated to pay the amount that make up its debts when due
The writer is associate professor of finance & accounting in IIM, Shillong